Advanced Search
MyIDEAS: Login to save this paper or follow this series

Debt dilution and sovereign default risk

Contents:

Author Info

  • Juan Carlos Hatchondo
  • Leonardo Martinez

Abstract

We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model à la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.richmondfed.org/publications/research/working_papers/2010/wp_10-08r.cfm
Download Restriction: no

File URL: http://www.richmondfed.org/publications/research/working_papers/2010/pdf/wp10-08R.pdf
Download Restriction: no

Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 10-08.

as in new window
Length:
Date of creation: 2012
Date of revision:
Handle: RePEc:fip:fedrwp:10-08

Contact details of provider:
Web page: http://www.richmondfed.org/
More information through EDIRC

Order Information:
Email:
Web: http://www.richmondfed.org/publications/

Related research

Keywords: Business cycles ; Financial institutions ; Financial markets;

Other versions of this item:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Diego Saravia, 2009. "On The Role and Effects of IMF Seniority," Working Papers Central Bank of Chile 538, Central Bank of Chile.
  2. Ceyhun Bora Durdu, 2007. "Quantitative Implications of Indexed Bonds in Small Open Economies," 2007 Meeting Papers 482, Society for Economic Dynamics.
  3. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets," Working Papers 2006-01, Banco de México.
  4. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
  5. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2009. "Heterogeneous Borrowers In Quantitative Models Of Sovereign Default," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(4), pages 1129-1151, November.
  6. Mark Aguiar & Gita Gopinath, 2007. "Emerging Market Business Cycles: The Cycle Is the Trend," Journal of Political Economy, University of Chicago Press, vol. 115, pages 69-102.
  7. David Backus & Silverio Foresi & Chris Telmer, 1998. "Discrete-Time Models of Bond Pricing," NBER Working Papers 6736, National Bureau of Economic Research, Inc.
  8. Kartik Athreya, 2008. "A Quantitative Theory of Information and Unsecured Credit," 2008 Meeting Papers 68, Society for Economic Dynamics.
  9. Harold L. Cole & James Dow & William B. English, 1994. "Default, settlement, and signalling: lending resumption in a reputational model of sovereign debt," Staff Report 180, Federal Reserve Bank of Minneapolis.
  10. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
  11. Jeffrey Sachs & Daniel Cohen, 1982. "LDC Borrowing with Default Risk," NBER Working Papers 0925, National Bureau of Economic Research, Inc.
  12. Gabriel Cuadra & Juan Sanchez & Horacio Sapriza, 2010. "Fiscal Policy and Default Risk in Emerging Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(2), pages 452-469, April.
  13. Athreya, Kartik B., 2002. "Welfare implications of the Bankruptcy Reform Act of 1999," Journal of Monetary Economics, Elsevier, vol. 49(8), pages 1567-1595, November.
  14. Ceyhun Bora Durdu & Ricardo Nunes & Horacio Sapriza, 2010. "News and sovereign default risk in small open economies," International Finance Discussion Papers 997, Board of Governors of the Federal Reserve System (U.S.).
  15. Dirk Niepelt, 2008. "Debt Maturity without Commitment," CESifo Working Paper Series 2500, CESifo Group Munich.
  16. Igor Livshits & James MacGee & Mich�le Tertilt, 2007. "Consumer Bankruptcy: A Fresh Start," American Economic Review, American Economic Association, vol. 97(1), pages 402-418, March.
  17. Satyajit Chatterjee & Burcu Eyigungor, 2010. "Maturity, indebtedness, and default risk," Working Papers 10-12, Federal Reserve Bank of Philadelphia.
  18. Lizarazo, Sandra Valentina, 2013. "Default risk and risk averse international investors," Journal of International Economics, Elsevier, vol. 89(2), pages 317-330.
  19. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Online Appendix to "Quantitative properties of sovereign default models: solution methods"," Technical Appendices 08-133, Review of Economic Dynamics.
  20. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
  21. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism," NBER Working Papers 13123, National Bureau of Economic Research, Inc.
  22. Krusell, Per & Smith Jr., Anthony A, 2001. "Consumption-Savings Decisions with Quasi-Geometric Discounting," CEPR Discussion Papers 2651, C.E.P.R. Discussion Papers.
  23. Paul R. Krugman, 1988. "Financing vs. Forgiving a Debt Overhang," NBER Working Papers 2486, National Bureau of Economic Research, Inc.
  24. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
  25. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  26. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  27. Guido Sandleris & Horacio Sapriza & Filippo Taddei, 2008. "Indexed Sovereign Debt: An Applied Framework," Carlo Alberto Notebooks 104, Collegio Carlo Alberto, revised 2011.
  28. Juan M. Sanchez, 2008. "The Role of Information in Consumer Debt and Bankruptcy," 2008 Meeting Papers 523, Society for Economic Dynamics.
  29. Martín González-Rozada & EduardoLevy Yeyati, 2008. "Global Factors and Emerging Market Spreads," Economic Journal, Royal Economic Society, vol. 118(533), pages 1917-1936, November.
  30. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
  31. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2013. "Why Do Emerging Economies Borrow Short Term?," Journal of the European Economic Association, European Economic Association, vol. 11, pages 67-100, 01.
  32. Asquith, Paul & Beatty, Anne & Weber, Joseph, 2005. "Performance pricing in bank debt contracts," Journal of Accounting and Economics, Elsevier, vol. 40(1-3), pages 101-128, December.
  33. Patrick Bolton & Olivier Jeanne, 2009. "Structuring and Restructuring Sovereign Debt: The Role of Seniority -super-1," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 879-902.
  34. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default in "Bad Times" ?," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 352-360, 04-05.
  35. Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, vol. 94(374), pages 287-307, June.
  36. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  37. Emine Boz & Christian Daude & C. Bora Durdu, 2011. "Emerging Market Business Cycles Revisited: Learning about the Trend," Koç University-TUSIAD Economic Research Forum Working Papers 1110, Koc University-TUSIAD Economic Research Forum.
  38. Sandra Lizarazo, 2009. "Contagion of Financial Crises in Sovereing Debt Markets," Working Papers 0906, Centro de Investigacion Economica, ITAM.
  39. Eduardo Borensztein & Olivier Jeanne & Paolo Mauro & Jeromin Zettelmeyer & Marcos Chamon, 2005. "Sovereign Debt Structure for Crisis Prevention," IMF Occasional Papers 237, International Monetary Fund.
  40. Francis A. Longstaff & Jun Pan & Lasse H. Pedersen & Kenneth J. Singleton, 2007. "How Sovereign is Sovereign Credit Risk?," NBER Working Papers 13658, National Bureau of Economic Research, Inc.
  41. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  42. Emine Boz, 2009. "Sovereign Default, Private Sector Creditors and the IFIs," IMF Working Papers 09/46, International Monetary Fund.
  43. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  44. Alfaro, Laura & Kanczuk, Fabio, 2009. "Optimal reserve management and sovereign debt," Journal of International Economics, Elsevier, vol. 77(1), pages 23-36, February.
  45. Juan J. Cruces & Christoph Trebesch, 2011. "Sovereign Defaults: The Price of Haircuts," CESifo Working Paper Series 3604, CESifo Group Munich.
  46. Jonathan Eaton & Raquel Fernandez, 1995. "Sovereign Debt," Boston University - Institute for Economic Development 59, Boston University, Institute for Economic Development.
  47. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
  48. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models," IMF Working Papers 10/100, International Monetary Fund.
  49. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  50. Manuel Toledo & Luis B. Marques & Fernando A. Alvarez, 2009. "Excess Volatility of Consumption in Developed and Emerging Markets: The Role of Durable Goods," 2009 Meeting Papers 142, Society for Economic Dynamics.
  51. Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University.
  52. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
  53. Bai, Yan & Zhang, Jing, 2012. "Financial integration and international risk sharing," Journal of International Economics, Elsevier, vol. 86(1), pages 17-32.
  54. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2007. "Quantitative models of sovereign default and the threat of financial exclusion," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 251-286.
  55. Alfaro, Laura & Kanczuk, Fabio, 2005. "Sovereign debt as a contingent claim: a quantitative approach," Journal of International Economics, Elsevier, vol. 65(2), pages 297-314, March.
  56. Detragiache, Enrica, 1994. "Sensible buybacks of sovereign debt," Journal of Development Economics, Elsevier, vol. 43(2), pages 317-333, April.
  57. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
  58. Alexander Guembel & Oren Sussman, 2009. "Sovereign Debt without Default Penalties," Review of Economic Studies, Oxford University Press, vol. 76(4), pages 1297-1320.
  59. Adrien Verdelhan & Nicola Borri, 2010. "Sovereign Risk Premia," 2010 Meeting Papers 1122, Society for Economic Dynamics.
  60. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2007. "A quantitative theory of unsecured consumer credit with risk of default," Working Papers 07-16, Federal Reserve Bank of Philadelphia.
  61. Oren Sussman & Alexander Guembel, 2005. "Sovereign Debt Without Default Penalties," OFRC Working Papers Series 2005fe17, Oxford Financial Research Centre.
  62. Juan Jose Cruces & Marcos Buscaglia & Joaquin Alonso, 2002. "The Term Structure of Country Risk and Valuation in Emerging Markets," Working Papers 46, Universidad de San Andres, Departamento de Economia, revised Apr 2002.
  63. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
  64. Li, Wenli & Sarte, Pierre-Daniel, 2006. "U.S. consumer bankruptcy choice: The importance of general equilibrium effects," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 613-631, April.
  65. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
  66. Ran Bi, 2006. "Debt Dilution and Maturity Structure of Sovereign Bonds," 2006 Meeting Papers 652, Society for Economic Dynamics.
  67. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
  68. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. repec:fip:fedreq:y:2012:i:2q:p:139-157:n:vol.98no.2 is not listed on IDEAS
  2. Gonçalves, Carlos Eduardo & Guimarães, Bernardo, 2012. "Sovereign default risk and commitment for fiscal adjustment," CEPR Discussion Papers 9163, C.E.P.R. Discussion Papers.
  3. Minetti, Raoul & Peng, Tao, 2013. "Lending constraints, real estate prices and business cycles in emerging economies," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2397-2416.
  4. Juan Carlos Hatchondo & Leonardo Martinez, 2013. "Sudden stops, time inconsistency, and the duration of sovereign debt," IMF Working Papers 13/174, International Monetary Fund.
  5. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  6. Satyajit Chatterjee & Burcu Eyigungor, 2013. "Debt dilution and seniority in a model of defaultable sovereign debt," Working Papers 13-30, Federal Reserve Bank of Philadelphia.
  7. Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University.
  8. John Hatfield & Fuhito Kojima & Yusuke Narita, 2012. "Many-to-Many Matching with Max-Min Preferences," Discussion Papers 12-020, Stanford Institute for Economic Policy Research.
  9. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 139-157.
  10. Demian Pouzo & Ignacio Presno, 2012. "Sovereign default risk and uncertainty premia," Working Papers 12-11, Federal Reserve Bank of Boston.
  11. Juan Carlos Hatchondo & Leonardo Martinez & Cesar Sosa Padilla, 2013. "Voluntary Sovereign Debt Exchanges," Department of Economics Working Papers 2013-13, McMaster University.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:fip:fedrwp:10-08. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (William Perkins).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.